Project 3

CAPM and Fama-French Three Factor Model

Professor Natalia Gershun
Reynold D’silva
Hanxiang Tang
Wen Guo
Part I: CAPM
Book Value per Share
The Book ¿ Market Ratio=
Market Value per Share
We use this function to get the BM ratio.

From the pictures above, you can see the two stocks we picked up. One is RIG which has big BM (book
to market) ratio and ACN which has small BM(book to market) ratio. If BM ratio is bigger than 1, it
means that the stock is undervalued and if less, it means overvalued. In our example, RIG is under-
valued and ACN is over-valued.

8) Report your estimate of beta and the standard error of beta, , from both regressions. Your report
should contain the Excel output from your regressions in the Appendix.

BETA Standard error

RIG 1.999204461 0.499289023
ACN 1.196702855 0.174105974

The beta of RIG is 1.999 and that of CAN is 1.196, the standard error of RIG is 0.449 and of CAN is 0.174.
Standard error is a measure of the statistical accuracy of an estimate, equal to the standard deviation of
the theoretical distribution of a large population of such estimates.

9) Construct 95% confidence intervals for your estimates of beta (see GE example in the notes on the
Empirical Issues and CAPM). Compare confidence intervals from both regressions and comment on the
difference in your results

Upper 95% Lower 95%

RIG 2.998279489 1.000129434
CAN 1.545088104 0.848317605

The 95% interval of RIG is from 1 to 2.999, which means we are 95% sure that the beta lies between 1
and 2.999.
The 95% interval of ACN is from 0.848 to 1.545, which means we are 95% sure that the beta of ACN lies
between 0.848 and 1.545.

10) Report R2 (coefficient of determination) from both regressions. What does R2 mean? Comment on
the difference between the coefficients of determination from two regressions.

R square
RIG 0.21367761
CAN 0.444673753

The table above shows the CAPM regression analysis of RIG, we can see that the R-Square is 0.2137
which means about 21% of the variation of the stock return can be explained by the return of S&P 500.
For the ACN, the R Square is 0.4447, which means that about 44% of the variation of the stock return
can be explained by the return of S&P500.

11) Test a hypothesis that  = 0 (since you run a regression through the origin) vs. the alternative that
0. It is a double sided t test.

T-statistic
RIG -1.655916333
CAN 0.557021394

Since we have 61 observations, the degree of freedom is 60. From the T table, we can see that the T
statistic should be 2 in order to be significant. Since the t statistics of both are all less than 2, we can
conclude that it is Null Hypothesis, which means that we are 95% confident that the alpha is supposed
to be zero.

12) Comment on your results: How well CAPM explains returns on large-cap value stocks and on small-
cap growth stocks.

From the above statistics, it is evident that CAPM is easier to calculate and comprehensible since it does
not contain multiple elements. It gives a decent idea of the beta estimate and the underlying error.
Based on the R-Squared value, It can be estimated that the model does not fit the data well since can’t
capture a high degree of variability. Also, T Statistic seems to be insignificant. This means that the return
on the stock is not representative of the return of S & P 500. However, on a comparable basis, CAPM
does a better job of explaining data for small cap than a large cap stock.
Part II-Factor Models:
For Question 1 & 2, please see Appendix at the end of the project.
3 a)Which beta coefficient are significant at the 5% confidence level (use t statistic)
RIG T-statistic
SMB 0.864547043
HML 4.739503751
Rm-Rf 3.721603198

We can see that the t-statistic of SMB is 0.8645, for HML its 4.7395, for Rm-Rf its 3.7216. Since the
absolute value of SMB is less than 2, its beta is not significant. For beta of HML and Rm-Rf, the absolute
values are higher than 2, which means they are significant under 5% level.

CAN T-statistic
SMB -0.92416
HML -0.548723338
Rm-Rf 6.907406444

Since the absolute values of beta(SMB) and beta(HML) are less than 2, they are not significant under the
5% level, but the t-statistic of beta(Rm-Rf) is higher than 2, so it is significant under the 5% level.

3 b)What are the coefficients of determination and what do they mean?

R-squared is a statistical measure of how close the data are to the fitted regression line. It is also known
as the coefficient of determination, or the coefficient of multiple determination for multiple regression.
It is the percentage of the response variable variation that is explained by a linear model. R-squared is
always between 0 and 100%:

-0% indicates that the model explains none of the variability of the response data around its mean.

-100% indicates that the model explains all the variability of the response data around its mean.

R-Square is used to check the variability of data and how well a set of data fits a particular model.
4)a) Report coefficients of determination and comment on the difference between two coefficients from
the regressions on your two stocks

Coefficients of determination(r square)

RIG 0.45470794
CAN 0.457565355

R-Square is the percentage of the response variable variation that is explained by a linear model. It can
be described as explained variation/total variation. The value of RIG is 0.4547 that is 45.47 % and for
ACN, 45.76% which states that the variability of ACN can be better explained by the model as compared
to RIG. It is to be noted that the model is almost identically fitted for both stocks. The model explains
almost half of the variability of the response data around its mean for both stocks. The model is more fit
for ACN than RIG based on the above results.

4 b) Compare individual coefficients from both regressions

We have two co-efficients, that is Beta and Alpha. If we compare the individual coefficients of both
regressions, we can see that beta which is the risk factor is low on both stocks of the Fama-French
model. Based on this information, Fama-French model would be much more viable since it further
reduces risk.

5) Compare and contrast results from the CAMP model and FF models for the large cap/value stock. Which
model seems to explain and predict returns better? Comment, using results of your regression analysis.

The Capital Asset Pricing Model (CAPM) states that the only relevant risk for assets is the systematic risk,
since investors can diversify idiosyncratic risk. On account of this, the expected return of an asset in the
CAPM is based on its systematic risk and the risk-free rate. In particular, systematic risk in the CAPM is
measured by one factor, the sensitivity of an asset to the market
The Fama-French Three-Factor-Model (TFM) is based on the Arbitrage Pricing Theory (APT) and is one
of the most famous models. The Arbitrage Pricing Theory states that systematic risk is of
multidimensional character and is therefore dependent on different economic risk factors. The CAPM in
comparison to the TFM was only dependent on beta as the sensitivity to the market. Fama and French
added to the beta factor two additional factors that shall have a relationship to the return of an asset or
portfolio. Fama / French observed that companies with different market capitalization but the same beta
showed highly differing returns. Moreover, the return also appeared to be dependent on the book-to-
market value.
As we can see the standard error for the Fama-French model is less while the co-efficient of
determination is higher. Also the data is much more significant. Based on the regression analysis using
both models, it is evident that Fama- French model does a better job of capturing variability and fits better
with the data so Fama-French model is more viable for analysis.

6) Does FF model outperform CAPM in explaining returns on the small cap/growth stock?

Compared to Large caps, CAPM does far better job on small caps which is evident from the R-Square
value. However, it is still not at par with the variability capturing ability of the fama French model. Both
models have insignificant T-values so it can’t be used as an effective yardstick for comparison. Also, the
scope for error is lower in the Fama-French model so FF seems the better model based on these
analogies. Fama-French was created to improvise on the drawbacks of the CAPM model so it is expected
to perform better on all standards.

Appendix：